This book, edited by Tomás J.T. Baliño and Carlo Cottarelli, addresses some of the strategic issues faced by policymakers in the choice of a monetary regime. Following an overview of some of these issues, the book considers the various theoretical or practical frameworks for the implementation of monetary policy. It then focuses on how monetary policy should be implemented.

The growth of derivative finance—the writing, trading, financing, and settling of forwards, futures, repos, swaps, puts, options, warrants, swaptions, and various combinations thereof, whose value is “derived” from the value of an underlying asset or price index—has become the key development in finance in industrial countries during the last fifty years. The growth in the use of derivatives has led to exponential growth in the total outstanding volumes of contracts. The total notional value of over-the-counter (OTC) and exchange-traded products has grown to exceed 10 trillion—more than twice the U.S. gross domestic product (GDP) from barely a trillion in 1987.

It is transforming the product mixes, balance sheets, and sources of revenue of financial intermediaries, and, indeed, it is accelerating a restructuring of the financial intermediary industry, as only a few money-center banks and securities houses emerge as the key participants in this new activity. The advantages offered by derivatives in hedging and position-taking have contributed to a decline of traditional interbank markets. Derivatives are changing the management of investment funds and have spawned a new class of collective investment vehicles—the hedge funds—dedicated to using the leverage achievable with derivatives to build speculative positions. The organization of financial markets and the methods of price discovery are being heavily influenced by the growth of derivative finance. The ability to use derivatives to create leveraged positions and the ease of arbitrage across derivative and underlying markets have increased the interaction and the volatility of prices of financial instruments. The developments in financial markets set in train by this growth of derivatives are making it harder to achieve monetary policy objectives and are inducing changes in monetary policy operating procedures. Finally, concerns about increased risk of systemic financial disturbances in derivative markets are forcing an overhaul of the supervisory, regulatory, legal, and accounting frameworks, including a reappraisal of who should be supervising what.

The key feature of derivatives is that they allow many common business risks (e.g., interest rate and exchange rate risk) to be separated from the production and financing activity that generates such risks. For example, the currency risk of cross-border investing or financing can now be separated from the decision on portfolio allocation, and the risk of interest rate changes can be separated from the funding decision. The risk of interest rates moving outside a chosen interval can be sold. Price volatility can be bought and sold. This “commoditization” of risk has made possible the trading of various risks, which has produced better pricing and a better allocation of risk among market participants—the main source of efficiency gains in derivative finance.

The growth of derivative finance in some ways parallels the introduction of “limited liability” shares in the early nineteenth century. The need to raise capital for colonial trading ventures and for large industrialization projects made it necessary to limit the investor’s risk. Limited liability allowed investors to acquire a share in a firm’s expected future earnings, putting at risk only the funds used to purchase the shares. The introduction of limited liability was an important first step in partitioning the probability distribution of returns from an investment to suit investors with different risk tolerance and different expectations. Innovation in communication and data-processing technology has made it possible for derivative finance to take this approach to the limit. It has isolated and “commoditized” various segments of the distribution of return on an investment or a portfolio.

The explosive growth in derivative markets and risk-management practices is posing major challenges for public policy on two fronts: in the area of prudential regulation and supervision, and monetary policy. First, the extensive use of complex derivatives and strategies (almost always booked off-balance sheet in a regulatory and accounting environment that remains focused on balance sheets) has made financial markets much less transparent, and it has created a nearly invisible web of connections among market participants. Thus localized disturbances are now more likely to get magnified and spread across markets, and it may well be more difficult for regulators to wall-off localized disturbances. Second, derivatives have increased the size of leveraged positions. Indeed, one of the main uses of derivatives has been to create leveraged positions, which means that there may well be less room for mistakes. The complexity of instruments and strategies and the high cost of expertise and hardware have also led to a concentration of business in a few large players, mostly banks and some securities houses.

Futures markets have also been used to create substitutes for deposit liabilities of banks. Institutional investors—pension funds, mutual funds, insurance companies—can guarantee a minimum value on liabilities deliverable in cash on short notice, irrespective of the value of the underlying asset. Derivative finance has, therefore, made it harder to achieve quantitative targets for monetary aggregates. Furthermore, in order to give clean and clear signals about monetary policy, most industrial countries stabilize overnight interest rates. But by eliminating spikes in overnight rates the central bank has become the liquidity supplier of last resort to the financial system; this in turn encourages further growth in derivative markets.

This paper provides a nontechnical overview of derivative finance and its implication for public policy. It first reviews briefly the major derivative instruments and markets. Next it discusses the risks in derivative finance and presents the challenges for supervision and regulation. The impact of derivative finance on monetary policy is then discussed before the conclusion of the paper.

Main Features of Derivative Finance

The Instruments

In general terms, a derivative instrument is an agreement to buy or sell a specified amount of an underlying asset or index by or at a specific date. The underlying asset can be a real commodity (e.g., wheat, crude oil), or it can be a financial instrument (e.g., Eurodollar deposits, shares of stocks), or it can be a notional asset (e.g., a ten-year notional French Government bond), an index of asset prices (e.g., Standard and Poor 500), or the spread between two interest rates (e.g., spread between the rate on U.S. treasury bills and Eurodollar deposits). Although derivatives come in very complicated forms and combinations, there are only two fundamental elements out of which all derivatives are built: forward contracts (an obligation to buy or sell) and options contracts (the right but not the obligation to buy or sell). And there are only two basic types of markets: (1) the market for OTC derivatives, which are written and traded by banks and customized according to quantity, maturity, etc., and (2) the organized futures exchanges, where derivatives (futures and options) with standardized features are traded with the exchange as counterparty. The most prominent OTC markets are in foreign exchange and interest rate forwards and options, interest rate swaps, currency swaps, and equity swaps. The most prominent exchange-traded derivatives are interest rate futures and options, and stock index futures and options.

The best-known example of a more sophisticated composite derivative is the interest rate, currency, or equity swap. A swap is equivalent to a series of forward contracts, in that it specifies an exchange of future cash flows, with the two types of payments being determined by reference to different underlying instruments of a specified notional face value. The swap has become one of the most successful derivative contracts. It is conceptually elegant and easy to execute. It has made it possible to hedge interest and exchange rate risk over very long time horizons. In addition, there are several successful combinations of derivatives—e.g., options on futures, options on caps, and options on swaps (swaptions). An important risk that is only beginning to be commoditized is credit risk. Such risk has so far been difficult to standardize. Efforts are under way to create indexes of credit risk—for example, an index of loss on residential mortgages in a particular region. As long as such indexes are viewed by the market as being free of manipulation, it is possible to write futures and options on the value of the index.

The Use of Derivatives

Derivatives allow the unbundling and securitizing of various risks affecting the value of an underlying asset or index,1 The most obvious use of derivatives is for hedging open positions in currency, interest rates (asset prices), and commodities. Hedging allows firms to reduce the volatility of their profit stream and thus, inter alia, allows greater leverage of a given amount of capital. For example, currency risk can be laid off by purchasing an over-the-counter foreign exchange option or a forward foreign exchange contract from a bank or by buying an exchange-traded option. Most foreign exchange options are written by banks and traded over the counter rather than traded on a futures exchange. The ability to lay a currency hedge over the foreign-currency-denominated portion of a portfolio allows the manager to separate currency decisions from asset decisions. Hedging interest rate risk is another important application of derivatives. Interest rate risk can be hedged with caps, floors, and collars written by banks, with forward rate agreements (mostly among banks), and with exchange-traded interest rate futures.

The main users of derivatives are financial institutions hedging their on- and-off-balance-sheet positions and institutional investors, including the so-called hedge funds. Corporates have started to enter this market in volume only during the last few years. The retail investor remains an insignificant player. For example, financial intermediaries hedge their interest rate mismatches, their currency exposure, and their off-balance-sheet obligations. Institutional investors, such as pension funds, insurance companies, and mutual funds, may want to protect their capital gains in the equity markets, insure currency risk, and immunize portfolios against interest rate changes.

Banks hedge their OTC book either dynamically if they write options, or through the purchase of futures on an organized futures exchange. Banks’ hedging strategies are complicated by the fact that many of the products they sell (e.g., caps, floors, collars, and swaps) cannot be hedged perfectly with existing exchange-traded instruments. A bank that writes an option becomes exposed to the possibility that the option will be exercised and that it will have to buy or sell what is underlying. The simplest hedge in this case would be to write a perfectly offsetting options contract. For example, if the original exposure resulted from having written a call option the bank could eliminate the exposure by buying a call option with the same terms, or by buying a put option and buying the underlying currency forward. For a bank that is active in the OTC options market and that maintains a large options book, some of the contracts it has written will tend to be offsetting in this way.

Alternatively, the bank can hedge its exposure by purchasing forward or futures contracts for the amount of foreign exchange it may have to deliver. If it has written an American-style option, which can be exercised at any time prior to maturity, the bank could hedge its exposure by buying foreign currency in the spot market and holding it until the contract matures. However, this would tie up funds for the duration of the option, and would not perfectly cover its exposure. The bank’s exposure from writing an option is associated with the possibility of having to buy or sell foreign currency at or before a specific date in the future. It is not necessary, therefore, to hedge the total face value of the contract. To determine how much of the face value to hedge (the hedge ratio), one must find a measure of the probability that the option will be exercised.

In theory, the behavior of derivative prices such as premiums for call or put options can be mimicked by the price behavior of a specific portfolio of positions in cash and in the underlying securities. Such a portfolio is referred to as a “synthetic option.” When a position in actual options is balanced by the opposite position in synthetic options, the overall position is perfectly hedged, but maintaining the hedge requires continuous dynamic adjustment of the cash and underlying security positions. Hence the term “dynamic hedging.”2

Another important use of derivatives is leveraged position-taking—the reverse of hedging. Corporate investors, financial institutions and institutional investors, and hedge funds may wish to establish leveraged open positions in interest rates, foreign exchange, equity, or commodity markets in anticipation of price movements. Since many of the derivative markets are at least as liquid as the market for the underlying asset or index, such position-taking is frequently done in the derivative markets. More importantly, a given amount of capital can be leveraged, through the use of derivatives, into positions that are many times larger than the initial capital investment. For example, an investor can establish a foreign exchange position in the OTC market by placing an initial amount of capital as margin deposit with a bank which then will write forward sales contracts with notional value anywhere from 5 to 50 percent of the margin amount. The investor may be called upon to provide further margin money if the exchange rate moves against him. The leverage ratio will depend on the volatility of the particular exchange rate and the bank’s relationship with the investor. Alternatively, the investor can purchase a foreign exchange option from the bank with his initial capital. Similarly, arbitrage across markets will usually involve trades in derivatives rather than in the underlying asset or index.

One of the key advantages flowing from the use of derivatives is the ability it affords in lowering funding cost through the diversification of funding sources through the swap markets. A borrower based in the United States can now borrow in the deutsche mark markets and swap the proceeds into U.S. dollars, thus eliminating currency risk. The reduction in borrowing costs occurs because the foreign lender is prepared to share the benefits he derives from having diversified his portfolio with exposure to the U.S. borrower. Similarly, some borrowers enjoy an advantage in long-dated fixed-rate funding. If such borrowers would like to have floating-rate debt, they can borrow in the fixed-rate market and swap into floating-rate payments. The swap will allow them to lower their overall borrowing cost.

Some derivative markets are more liquid than the underlying markets, particularly futures contracts on stock indexes. It is, therefore, possible to use derivatives to lower transaction costs associated with certain types of position-taking.

Structure of the OTC Derivative Industry

The OTC market has been the fastest growing segment of the derivative industry. It allows customers to hedge their particular risk with instruments that are tailored to their needs with regard to quantity, maturity, credit requirements, strike prices, and many other features. The major intermediaries or dealers in the OTC derivatives markets tend to be large banks and securities firms in the United States, Japan, France, the United Kingdom, Germany, and Switzerland. Banks have been attracted to dealing in OTC derivatives as a way of expanding the menu of interest rate and currency risk management products that they have traditionally provided to their customers.

Among U.S. banks, a handful of large institutions are the main dealers in OTC derivatives, accounting for much of the position-taking.3 Bank holding companies with total assets of at least 10 billion hold between 98 and 100 percent of the notional value of all positions taken by U.S. bank holding companies in various types of OTC and exchange-traded derivatives. This concentration of activity has been relatively stable since 1990, when the data were first compiled. The smaller institutions tend to be end-users that typically take on derivatives positions to manage risks associated with their traditional banking activities.

Bank participation in markets for exchange-traded interest rate futures and options is also extensive. These instruments are used by banks in part to hedge their net OTC derivatives position and their on-balance-sheet interest rate risk. With respect to open futures positions, available data indicate that banks are most heavily involved in futures on short-term interest rates, such as the three-month Eurodollar contract. At end-December 1992, reporting banks accounted for 35 percent of long open positions and 38 percent of short open positions in contracts on short-term interest rates. Banks account for 23 percent of long positions in currency futures and 20 percent of short positions, while in futures on stock market indices, banks hold 27 percent of all long positions and 22 percent of short positions.

Available data on banks’ open positions in listed options suggest that banks are major participants in options on short-term interest rates. For example, at end-1992, reporting banks wrote 49 percent of put options on short-term interest rates. As far as other option contracts are concerned, non-U.S. banks are active as both purchasers and writers of options on currency futures. However, banks are not very active in the market for options on futures on stock market indices.

The OTC Market and the Futures Exchanges

It is not immediately apparent why some contracts are predominantly written and traded over the counter by banks, like foreign exchange options, while others are mostly traded on organized exchanges, like interest rate futures. In the latter case, interest rate forward contracts (the so-called forward agreements) are also written by banks. Exchanges compete with banks and among each other to list successful contracts. OTC contracts have the advantage of being tailored to the customers’ needs with regard to maturity, strike price, credit guarantees, and other features. The bulk of swap contracts could easily be decomposed into a standard part and a customized part, in which case the standard part could then be traded on an exchange. Exchanges traditionally impose stricter margin requirements and risk-sharing arrangements on the clearinghouse members than banks impose on their customers. Banks instead rely on their ability to analyze credit in screening their derivative customers.

Growth of Derivative Markets

The outstanding notional principal value of OTC instruments (mostly interest rate and currency swaps) increased to 6 billion by 1993, an increase of over 500 percent from end-1987. The notional principal of exchange-traded derivative instruments has also registered strong growth, climbing to 5.5 trillion by 1993, up almost 500 percent from end-1987. The growth in derivative instruments has outpaced by a wide margin that of other financial instruments. As a rough indication of this trend, the ratio of the outstanding notional value of interest rate and currency derivative contracts to the international assets of banks rose from around 31 percent at end-1987 to 120 percent in 1993. The most actively used OTC instruments are interest rate swaps, the notional principal value of which totaled 4 trillion in 1993, up 400 percent from end-1987. The market for currency swaps, including cross-currency interest rate swaps, has also experienced rapid growth. The notional value of these swaps reached 1 trillion in 1993, an increase of 400 percent from end-1987. The OTC markets also include caps, floors, collars, and swaptions. At end-1991, the aggregate notional value of these instruments stood at over 1 trillion, an increase of nearly 50 percent from end-1989.

The most actively traded financial derivatives on organized exchanges are futures on interest rates. Trading volumes in these instruments totaled 250 million contracts in 1991, up 60 percent from that in 1987. The bulk of this activity is concentrated in U.S. Treasury bonds and three-month Eurodollar futures. However, trading volumes in the notional French government bonds—Obligations Assimilables du Trésor (OAT)—and German bond futures have increased significantly in recent years. Interest rate options and options on interest rate futures are also actively traded on organized exchanges. The volume of interest-rate-related option contracts outstanding worldwide totaled 50 billion in 1991, up from a few hundred million in 1987.

Risks in Derivative Finance

A number of recent examples of significant losses incurred by some major firms have shown that derivatives have to be handled with care. The German firm Metallgesellschaft lost 2.3 billion from the derivative trading of a subsidiary. The subsidiary had sold five-year and ten-year oil contracts to end-users and hedged this short position in the underlying instrument with one-month and two-month oil futures (it could not obtain longer-dated forward contracts because no counterparty was willing to take the credit risk). Initially the maturity mismatch generated profits, but then short-term prices fell below longer-term prices and the maturity mismatches produced huge losses. Similarly the Chilean mining firm Codelco sustained significant losses recently (several hundred million U.S. dollars) when a single trader tried to recoup losses from a trading mistake with aggressive positioning. Thus concerns that the speed with which these markets have expanded and that the complexity of many of these instruments has resulted in a weakening of risk management appear to be well founded. Some of the recent products may not be well understood by either senior management of banks or by supervisors.

In addition to the risk from derivatives incurred by individual users, there is the risk of systemic failures in markets owing to liquidity crises produced by the failure of a large market participant or by operational problems (payments system failure, computer or communications breakdown). Derivative markets rely heavily on liquid securities markets and liquid markets in nearly-instantaneously-deliverable “good funds.” Finally, participation in derivatives markets can cause firms to become connected through complicated transactions in ways that are not easily understood, making the evaluation of counterparty risk extremely difficult. While there is no doubt that enormous benefits have accrued to participants through the skillful use of derivatives, these benefits have been somewhat offset by the increase in systemic risk, the cost of which will ultimately have to be borne by the public sector.

Credit Risk

Credit risk derives from the extension of credit to counterparties who may be unwilling or unable to fulfill their contractual obligations. For derivative instruments the current credit exposure is measured by the positive value, or replacement cost, of the contract. For exchange-traded derivatives the evaluation and management of credit risk is facilitated by the design of the market. Credit exposures are limited by the existence of a nearly-continuous market in the contracts and by the requirement that positions be marked to market at the end of each trading session. Performance bonds and maintenance margins provide a degree of protection against default by any one participant, while the reserves of the clearinghouse itself and the access to bank lines of credit by the clearinghouse and members of the exchange provide protection to all members against the failure of any one participant.

In contrast, OTC contracts, especially longer-dated ones, can generate significant credit exposures. The measurement of credit exposures in OTC derivatives is complicated by lack of standardization. Credit risk in OTC contracts written by nonbank securities houses, particularly in longer-dated swap contracts, has meant that such firms have begun to develop credit risk evaluation expertise much as banks have. Some banks have begun to mark OTC contracts to market and to require periodic margin payments, but the absence of a market for many of these contracts means that it is more difficult to determine capital gains and losses on a continuous basis. The replacement cost of an OTC derivative is obtained by recalculating the theoretical value of the contract as the parameters of the pricing equation change.

For OTC derivatives such as swaps that do not contain options, the initial replacement cost of the contract is zero since no payment is made at the time of inception. However, once the market price of the underlying instrument moves, the value of the contract will change: becoming positive for one party and negative for the other. The owner of a contract with a positive value has a claim on the counterparty and therefore is exposed to credit risk.

An option does have a positive value at inception—the premium. Over time, and as the price of the underlying instrument changes, the value of the option changes. However, since the value of the option can never be negative, the purchaser of the option will always have a credit exposure to the contract’s writer unless the option has a zero value.

The current credit risk of a swap contract is calculated as the present value of the net payments the holder expects to pay and receive over the life of the contract. Similarly, for options, the current credit risk can be measured by pricing the option using standard formulas. However, estimating future credit exposures can be very difficult, since the future value of a derivative contract depends on the future values of the underlying instrument and the interest rate that must be forecast. Therefore, the reliability of the forecast itself adds to the risk factor.

Credit risk is generally managed by establishing exposure limits for each counterparty. The most obvious example of this is the requirement that counterparties have investment-grade credit ratings (triple B or above).4 A substantially higher credit rating—AA or higher—is typically necessary for institutions that are dealers in the OTC market, in particular for nonbank financial institutions. Owing to concern about their credit standings, three U.S. securities firms—Merrill Lynch, Goldman Sachs, and Salomon Brothers—have recently set up units for their swap business that have been separately capitalized and organized so as to qualify for a triple A rating.

Once the decision has been made to accept a particular counterparty exposure, the extent of that exposure must be managed. Dealers typically manage both on-balance-sheet and off-balance-sheet credit limits in a centralized unit for a given market, if not globally, to avoid large exposures for the institution as a whole. The overall credit limit for any one counterparty often reflects the expected return and risk associated with the claims on it, with riskier counterparties tending to pay a higher premium in the form of a wider bid-ask spread to undertake a transaction. In fact, the widely posted quotes for swaps are for triple A counterparties only; those with lower rating are often given different quotes.

The bilateral netting of swap contracts provides a means to curb the escalation of these risks, provided that the provisions are legally enforceable.5 The new 1992 master agreement developed by the International Swaps and Derivatives Association (ISDA) provides for both payment netting (to reduce the periodic cash flows associated with swaps) and netting of claims in the event of default. Moreover, in the United States, provisions in recent banking reform legislation and an amendment to the bankruptcy law ensure that agreements calling for the netting of claims are legally enforceable in the event of default. The legal standing of netting provisions of the new ISDA master agreement outside the United States, however, is not altogether certain. While the ISDA has obtained legal opinions in each of the other Group of Ten countries that the netting provision would be legally enforceable if challenged in court, the agreement has not yet faced such legal challenges.

While notional amounts of derivative volumes serve to identify institutions that are active in the derivatives markets, these figures do not provide a useful gauge of credit exposures. The notional amounts are simply hypothetical principal values used to calculate the contractual cash flows that generate the actual credit exposures. The credit exposure of a derivatives contract is the cost of replacing the contract if the counterparty defaults; in other words, it is the positive market value of the contract, if any. These exposures generally amount to only a small fraction (roughly 2 to 4 percent for interest rate swaps) of the notional values.

U.S. banks report the replacement cost of interest rate and currency swaps as part of their compliance with the Basle Accord. The bulk of the credit exposure is concentrated in ten banks, the aggregate credit exposure of which was 170 billion (17.3 percent of their total assets) at end-September 1992. Relative to the total assets of these banks, their credit exposures ranged from 3.2 to 33.4 percent. Moreover, 69 percent of total credit exposure (117.7 billion) is associated with exchange rate contracts, despite their smaller aggregate notional principal amounts. This reflects the fact that currency swaps involve an exchange of both a stream of interest payments and a principal amount.

Market Risk

Market risk refers to the change in the value of an open position due to a change in the price of the underlying instrument and hence to interest rates. Unlike credit risk, market risk is generally managed on a portfolio basis rather than on a counterparty basis. This allows banks to set market risk to any desired level. Since dealers frequently enter into offsetting positions with different counterparties6 and generally hedge the remaining net position, the sensitivity of the overall portfolio to changes in the price of an underlying instrument can be minimal. Hedging can complicate the management of credit risk through the practice of reducing market risk by taking new positions, rather than by unwinding existing ones. In effect, market risk is managed by taking on greater credit risk.

The price of a futures contract is linearly related to the value of the underlying cash contract, and the value of a swap is also linearly related to the difference in the value of the two payments streams, e.g., a fixed-rate and floating-rate bond. Hence market risk on futures and swaps can be hedged with long positions in cash instruments, or with one another. However, the value of an option changes with changes in the price of the underlying instrument (delta), with changes in interest rates (rho), with changes in time to maturity (theta), with changes in volatility in the price of the underlying instrument (vega), and finally, the option’s delta itself changes with changes in the price of the underlying instrument (gamma). These sensitivities of the market value of the options can only be hedged perfectly with other options. Thus the hedging of options depends on the liquidity of options markets. If no offsetting back-to-back options transactions are available to hedge a given options portfolio, then the portfolio will need to be dynamically hedged. Hedges can only be established for given times to maturity and given prices of the underlying instrument, and hence continuous trading is necessary to adjust hedges. Several markets, particularly the futures exchanges, need to be liquid if such hedge adjustments are to be made promptly. In crisis situations prices move very fast and rehedging will need to be done very fast. If a substitute instrument is used to hedge options, then the position is subject to basis risk—i.e., the risk that the price of the substitute will diverge from the price of the underlying instrument.

Legal Risk

Legal uncertainties have actually been responsible for the most significant losses to date in derivatives markets and continue to present perhaps the greatest risks. The most prominent example of this is the defaults by some U.K. local authorities on their swaps contracts.7 A unique feature of the financing by local authorities is their access to fixed-rate loans on the finest terms from a government agency that passed on the government’s comparative advantage in fixed-rate borrowing. In addition, since local authorities’ income and expenditures tend to move in line with nominal interest rates, a number of authorities sought to obtain low-cost variable-rate loans by borrowing from the government at fixed interest rates and simultaneously entering into an interest rate swap to pay a variable interest rate and receive a fixed rate. However, in January 1991, the U.K. local authorities were found by the House of Lords to have entered into the swap contracts without the legal right to have done so. Subsequently, defaults by local authorities have resulted in losses to their counterparties.

In the United States, the most important source of legal risk is the possibility that the Commodity Futures Trading Commission (CFTC) would apply the Commodity Exchange Act’s (CEA) prohibition against off-exchange trading to swaps. Under the CEA, a futures contract not traded on a designated exchange is illegal. Because swaps have certain futures-like characteristics, this restriction has raised concern that some OTC derivatives would be found to be illegal off-exchange futures. In February 1993, the CFTC established a set of rules to exempt swaps and related derivative instruments from most provisions of the CEA. These new rules were issued under the expanded exemptive authority received by the CFTC under the Futures Trading Practices Act of 1992.

The new rules place several conditions on the exclusion of these transactions from the CEA, however. In particular, to qualify for exclusion, the instruments cannot be part of a fungible class of instruments that are standardized and the instruments cannot be traded on a physical or electronic trade execution system. Moreover, the CFTC previously issued a policy statement in 1989 that characterized a swap as an instrument having individually tailored terms, commercial and institutional participants, and the expectation of being held to maturity.

A major source of legal risk is the uncertainty surrounding the legal enforceability of netting arrangements among market participants. Under such arrangements, the exposure arising from multiple derivative transactions is netted. Informal industry estimates suggest that exposure reductions of more than 50 percent are achievable through bilateral netting. In the swaps market, master agreements with netting provisions have come into use in which transactions are automatically netted. Without legal certainty, however, the receiver of a bankrupt counterparty might repudiate the agreement and demand payment on all contracts with positive value (“cherry picking”), while placing the holders of contracts with negative value among the general creditors.8

Systemic Liquidity Risk

Liquidity is the life blood of derivative finance. Derivative markets function well only in an environment where the markets for the underlying instruments and for the derivatives themselves remain liquid. Liquid markets are a necessary condition to be able to hedge an options portfolio; dynamic hedging requires continuous trading. Discrete price movement—gaps in markets—will cause dynamic hedging to be ineffective and lead to losses. In addition, derivative markets make great demands on the ability of the financial system to deliver intra-day “good funds.” A high degree of leverage implies that small price movements lead to large gains and losses throughout the trading day. Such gains or losses are marked to market frequently enough to avoid the buildup of excessive credit positions. The losers are required to settle positions by meeting margin calls, frequently intra-day. It is, therefore, essential that the financial system have a payments mechanism that can deliver intra-day good funds in great volume. In addition, trading volumes in derivative markets have resulted in a large increase in the payments flows through the wholesale payments system. Again, it is necessary that such payments can be made safely and without delay. The gravest risk to a financial system with large derivative positions is a payments illiquidity.

Regulators have at times raised concerns about the risk of a systemic disturbance arising from derivative markets. The rapid growth of activity in derivative instruments has tended to strengthen the linkages between market segments, both within countries and across borders. These links have emerged from the capacity of derivatives to unbundle and reallocate the risks associated with positions in the markets for the underlying instruments. The tendency for derivatives to create arbitrage opportunities and to strengthen the linkages between markets has increased the possibility that disruptions or increased uncertainty in these markets might spill over into other derivatives markets and into the cash markets more readily than in the past.9 Indeed, a seasoned observer has noted recently that “the expansion of market linkages, which cut across national boundaries and embrace a wide range of financial and nonfinancial firms, raises concerns about the ability of central banks to contain systemic difficulties should they emerge.”10 Such linkages to other markets were also stressed in the report prepared by the Group of Ten central banks on recent developments in international interbank relations (the so-called Promisel Report). In addition, there is concern among regulators that risk in the OTC market is overly concentrated in the hands of a few major players, that risk is systematically underpriced, and that the financial safety net would have to be expanded beyond the banking system to cover nonbank financial intermediaries. Finally, derivative markets suffer from a lack of transparency. It is difficult for market participants to assess the consolidated exposure inherent in the derivative books of major players. In such a situation, a firm that is experiencing difficulties might find that its continued access to financing is denied by the precautionary reaction of other market participants.

The risk that the act of selling an existing position in derivatives will have a significant impact on the price—liquidity risk—is impossible to hedge and difficult to assess. In the OTC market, where instruments are tailor-made for a particular group of clients, there is in any event less liquidity than in more homogeneous exchange-traded products. For this reason, market makers with uncovered positions at the end of a day’s trading will cover either by taking opposite positions in the futures markets or by synthesizing an opposite position via use of dynamic hedging techniques. The use of such dynamic hedging methods can itself generate liquidity problems because they often mandate sales of underlying securities when prices fall or purchases when prices rise; this can trigger an avalanche of sales into a relatively illiquid market for the underlying security, thereby collapsing the price or causing a breakdown in trading.11 Thus, the presence of liquidity risk puts limits on the reliability of the methods used to control market risk and should generate skepticism over claims that risk control software has eliminated market risk as a matter of concern.

The most important problems with dynamic hedging are based on more fundamental features of asset pricing. Standard option-pricing formulas do not allow for the possibility of jumps in exchange rates as, for example, the realignment of ERM central parities. Thus, an out-of-the-money option has a very low delta and would not therefore be aggressively hedged. A surprise realignment, however, could greatly increase the delta, leaving a bank underhedged. Moreover, the construction and maintenance of the hedge portfolio require the ability to trade both the underlying asset and its derivatives continuously. If for some reason any of these markets become illiquid, the hedge breaks down.

Pricing and Valuation Risks

Although derivative-pricing models have advanced well beyond the standard options-pricing model, they still suffer from the weakness that structural changes lessen the usefulness of historical data in estimating parameters for pricing models. The valuation of longer-dated options is particularly difficult in the face of structural uncertainty.

The internal risk-management models in use at the major financial institutions all rely on proprietary pricing models that are not easily accessible to regulators. It is difficult to assess their performance in times of stress when liquidity might be scarce. Such models might also be subject to the fallacy of composition, in that they place most participants on the same side of the market. For example, a significant market drop may well lead to a further sell-off as dynamic hedge programs try to maintain coverage.

The Challenge for Supervision and Regulation

Considering the phenomenal growth of the OTC derivative markets, the potential for systemic risk, and the fact that this relatively complicated subject is admittedly not yet fully understood by either senior bank managers or senior regulators, it is not surprising that questions have been asked about the adequacy of the existing regulatory framework. Several regulatory initiatives are under way to improve the prudential supervision of OTC derivative activities.

The main efforts to limit the potential for systemic risk have been three-pronged, aiming (1) to strengthen individual institutions through appropriate financial policies, (2) to improve the functioning of payments and settlement systems, and (3) to improve market and trading infrastructure, such as multilateral clearinghouses for derivatives.

Capital Adequacy Standards

Traditionally bank regulators have used capital requirements as a tool to ensure that banks have sufficient capital to absorb potential losses without becoming either a liability to the deposit insurance fund or posing a systemic threat to the financial system. Capital requirements have been specified as a minimum risk-weighted required ratio of equity or total balance sheet assets. This has become inappropriate with the growth of off-balance-sheet derivative transactions. Since many OTC derivative products do not require initial capital outlays, and the calculation of a capital charge (reserve) for covering potential future default is somewhat flexible, banks might not have the right incentive, under severe competitive pressure, to put up the appropriate capital reserve. In any event, the optimal capital reserve for an individual bank, under the assumption that other major financial institutions are in sound condition and markets remain liquid, might be too low to maintain the soundness of the financial system as a whole as the effect of a major failure is not being considered. In other words, the positive externality of higher capital reserve of an individual bank to the system may not be reflected appropriately in the objective function of the bank.

The Basle Proposal and the EC Directive

In March 1993, the Commission of the European Communities (EC) issued a Capital Adequacy Directive to modify and supplement its 1989 directives for capital requirements of credit institutions in the EC member states. In May 1993, the Basle Committee on Banking Supervision released for comment a set of proposals to revise the 1988 Basle Capital Accord for setting minimum capital requirements for banks in the Group of Ten countries. The Basle proposals are largely in line with the new EC Capital Adequacy Directive, with differences remaining only in the specifics.

The main conceptual innovations in the new EC Capital Adequacy Directive and the Basle proposals are: (1) the separate recognition of the loan book and the trading book of credit institutions; (2) the adoption of a building-block approach under which specific risk (including credit risk, settlement risk, liquidity risk, etc.) is distinguished from general market risk that involves unexpected changes in general market price level, interest rates, and exchange rates; and (3) the introduction of capital requirements for general market risk from a portfolio perspective.

Owing to the leveraged nature of positions in the trading book, market risk can be very important relative to credit risk, which was the main focus of the 1988 Basle Capital Accord and the two 1989 EC directives. The Basle Committee is proposing a separate treatment of general market risk and specific risk, with the latter including credit risk, settlement risk, and risk of adverse movement in the price of an individual security unrelated to the movement of the market. The Committee adopts a building-block approach to aggregate specific and market risk. The minimum standard is calculated according to an x plus y formula, in which x (denoting specific risk) is applied to the gross positions while y (denoting general market risk) is applied to the net positions (after offsetting long and short positions).

Unlike credit risk, which is counterparty specific, the risk of an unfavorable change in interest rates or exchange rates can affect many positions in the book simultaneously. As such, the approach taken in the 1988 Basle Capital Accord—which computes the total capital charge to cover the risk of default as the sum of capital reserves for individual positions—is clearly inappropriate. This is the rationale behind the explicit recognition of offsets and the accounting of market risk from a portfolio perspective in the new proposals.

In general, the various components of market risk are neither uncorrelated nor perfectly correlated. Hence, to compute the capital requirement to cover, say 95 percent, of all possible losses, the relations between all these risk elements have to be explicitly modeled and specified—a difficult task given the dimension of the problem. Furthermore, these relations are likely to be changing from time to time, making the establishment of capital adequacy rules very difficult. For practical reasons, the Basle Committee and the EC Commission, therefore, have adopted an approach whereby the capital charge for each risk element is computed separately. These separate capital charges (for different risk elements) are then summed to give the total capital requirement. It can be shown that this is equivalent to assuming perfect correlation between the risk elements.

A key general market risk is fluctuations in the term structure of interest rates. Both the Basle Committee and the EC Commission have devoted substantial efforts to the measurement of interest rate risk and the setting up of capital requirements to cover this particular risk factor. Their standard approach, which can also be called a maturity ladder approach to measure interest rate risk, involves setting up: (1) a small number of maturity bands (instead of a continuum of maturities); (2) a representative duration measure for each band (instead of a duration measure for each instrument); and (3) a benchmark interest rate change for each band. Under the approach, each position is converted into a combination of simple debt instruments which are then classified into maturity bands.

Each converted position is then weighted by a risk weight that is the product of the representative modified duration measure for the maturity band and an assumed interest rate change for the particular maturity band. The capital requirement is then calculated as the sum of the weighted positions (where positive and negative positions can cancel or offset each other). However, to recognize that positive and negative positions in the same maturity band might not be perfect hedges for each other owing to the size of each maturity band and the existence of basis risk, gap risk, and spread risk, the Basle Committee imposes a vertical disallowance. This is an additional capital charge computed as 10 percent of the capital charge for the matched long and short positions.

Furthermore, to recognize that positive and negative positions in different maturity bands are not perfect hedges for each other (the yield curve need not move in a parallel fashion), the Basle Committee also proposes to impose horizontal disallowances. Since positions from far-apart maturity bands are even worse offsets, as the yield curve does not necessarily move in a parallel fashion, capital charges are increased accordingly. For this purpose, the Committee has proposed to group the maturity bands into three different maturity zones. Within-zone horizontal disallowances are smaller than across-zone disallowances. Also, disallowances for adjacent zones are smaller than disallowances for nonadjacent zones.

While the EC Directive does not mention explicitly vertical and horizontal disallowances, the way of computing capital requirements under the directive is essentially equivalent to the imposition of such disallowances as matched and unmatched positions within and across maturity bands are assigned different weights to take into account risk due to hedging with nonidentical instruments.

Measuring Exchange Rate Risk

Exchange rate risk is the risk of loss from unhedged or imperfectly hedged foreign currency positions. To determine the amount of capital needed to cover most potential losses that are due to unexpected exchange rate fluctuations, it is necessary to determine (1) the sensitivity of the entire trading book with respect to such fluctuations, and (2) a critical level of assumed exchange rate changes. The first task is complicated by the presence of foreign exchange derivatives, including foreign exchange options, forwards, futures, and currency swap positions, which can depend on the exchange rates in rather complicated ways. Hence, strictly speaking, to achieve (1) and (2), the behavior of all relevant exchange rates has to be modeled, correlations need to be taken into consideration, and the future profits and/or losses of the entire portfolio should be simulated. However, such modeling and computations can be too complicated and expensive for small banks without a sophisticated risk management system. Hence, while allowing competent institutions to follow the simulation approach (subject to some requirements), the Basle Committee has also proposed a shorthand method for measuring foreign exchange risk.

Under the shorthand method, the capital requirement is computed as 8 percent of the net open currency position of the institution. The net open position is arrived at by adding the greater of the sum of the net short positions for every currency and the sum of the net long positions for currencies. The net short or long position for a currency is calculated by summing (1) the net spot position, (2) the net forward positions, (3) guarantees that are certain to be called and are likely to be irrecoverable, (4) net future income or expenses not yet accrued but already fully hedged, (5) the net delta equivalent of the total book of foreign currency options, and (6) any other item representing a profit or loss in foreign currencies. Furthermore, all currency positions are converted at the spot rates into a reporting currency. The Basle Committee also proposed that the national supervisors would have discretion to exempt a bank from capital requirements on its foreign exchange positions if the bank has negligible business in foreign currency and does not take foreign exchange positions for its own account.

Netting

The 1988 Basle Capital Accord recognizes only netting by novation for the purpose of calculating capital requirement. Netting by novation is a bilateral contract between two counterparties under which any obligation to each other to deliver a given currency on a given date is automatically amalgamated with all other obligations between the parties for the same currency and value date, so that there is a legal replacement of one single net amount for the previous gross obligations. In the April 1993 proposal of the Basle Committee, the offsetting of credit exposures for capital requirement purposes is extended to cover any bilateral netting that is effective under relevant laws and complies with the minimum standards recommended by the 1991 Lamfalussy Report.

In 1989 the U.S. Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) had recognized close-out nettings and prohibited “cherry picking” behavior at liquidation. In 1990, the Bankruptcy Code Amendment was adopted. It validated close-out netting provisions of swap agreements by adding a new Section 560 to the Bankruptcy Code. In 1991, the Federal Deposit Insurance Corporation Improvement Act (FDICIA) was passed. It validated netting contracts between financial institutions, the definition of which was clarified later by the Federal Reserve Board in May 1993. Unlike the FIRREA and the Bankruptcy Code Amendments, the FDICIA does not define or list covered transactions. This would make the enforceability of cross-product netting more likely. These legal developments have cleared the way for more general recognition of netting for the calculation of capital requirements.

Under the new Basle proposal, the credit exposure on bilaterally netted forward transactions is calculated as the sum of the net marked-to-market replacement cost, if positive, plus an add-on based on the notional underlying principal for banks using the current exposure method. Specifically, the replacement cost for individual transactions subject to bilateral netting arrangements is recorded on a net basis to produce a single credit or debit position for each counter-party. However, in terms of the add-ons, the Committee recommends keeping the guidelines given in the 1988 Basle Capital Accord—that is, add-ons will be calculated by multiplying the total notional amount of each transaction by a percentage. For interest rate contracts, the add-on percentage is 0.5 percent for contracts with a maturity of one year and over. There is no add-on for interest rate contracts with less than one year to maturity. For exchange rate contracts, the add-on factor is higher. This is due to the more risky nature of exchange rate contracts, as they involve an exchange of principal amounts on maturity, and exchange rates are generally more volatile than interest rates. The add-on factor for exchange rate contracts with less than one year to maturity is 1 percent. The add-on factor for exchange rate contracts with maturity of one year and over is 5 percent.

The industry generally welcomes the recognition of bilateral netting as this can reduce capital requirement. The Bank for International Settlements has estimated that the capital requirement for swap dealers can be reduced by 25 to 40 percent. The ISDA estimated that the recognition of bilateral netting can reduce the capital requirement by as much as 48 percent.

Payments System Risk Reduction

The explosive growth of trading in derivative products and other securities has greatly increased payments traffic through the world’s major domestic and international payments systems. In the past five years, these mounting pressures on payments systems have spurred central banks to implement mechanisms to control associated credit risks. Nonsettlement of a bank’s payment obligations in a particular currency would either impose a loss directly on the central bank or trigger a systemic problem. To reduce credit risks, caps can be placed on daylight overdrafts in gross payments systems (systems in which payments messages sent by payor banks coincide with the receipt of “good funds” by the payee bank) or on daylight net debit positions on net end-of-day payments systems. Such limits have been imposed on the Fedwire and Clearing House Interbank Payments System (CHIPS) in the United States and are planned for the Système Interbancaire de Télécompensation (SIT)—Interbank Teleclearing System—in France.

In addition, some systems have either imposed a partial collateral requirement on net debit positions (CHIPS) or have formally announced intentions to shift to a real-time gross settlement with fully collateralized overdrafts—the Clearing House Automated Payment System (CHAPS) in the United Kingdom. The Swiss Interbank Clearing (SIC) system has already shifted to the latter mode of operation. Such changes are still in the planning stage for other countries. A difficulty with these proposed reforms is that they will tend to reduce liquidity in money markets and may have to be accompanied by liquidity facilities provided by the central bank.

OTC Versus Multilateral Clearinghouses

One important advantage of the organized exchanges is that they have robust mechanisms in place to reduce credit risk. This has given rise to questions of whether risk reduction could also be achieved by channeling more of the OTC business to the organized exchanges. Margin requirements and loss-sharing arrangements have gone a long way toward eliminating credit risk among members of the exchanges, as well as the risk of spillover from a major default. However, banks that satisfy capital requirements may be as creditworthy as some clearinghouses. Moreover, since banks support clearinghouses and exchange members with lines of credit, the ultimate protection from liquidity risk is the same in both markets. It is generally agreed that capital regulations in the OTC markets ought to establish or maintain a level playing field for competition between the exchanges and OTC. The problem is that it is not entirely clear what “level” means. At the heart of this question is the concern that the massive growth in OTC business has occurred because the obligations of major banks and their liquidity are implicitly guaranteed by the financial safety net.

Data, Accounting Standards, and Disclosure

The rapid growth of derivative markets has meant that the collection of regulatory and supervisory data on turnover, positions, and activities—broken down by markets, instruments, and participants—is lagging somewhat behind. Efforts are now under way by national supervisors and by the Bank for International Settlements (BIS) to improve data gathering and the quality and timeliness of data. Similarly, accounting standards have been slow to adjust to the new environment. In particular, requirements to mark off-balance-sheet positions to market are currently being overhauled. Finally, supervisors are also re-examining disclosure requirements.

Liquidity Management and Monetary Policy

Liquidity Management

An increased demand for liquidity is a key characteristic of evolving financial systems. In financial systems with highly securitized derivative markets, such as those of the United States and the United Kingdom, there exists an intricate network of short-term obligations connecting diverse financial institutions. Brokers and dealers rely on liquid repurchase markets to finance their positions. Nonbank financial institutions, as well as the corporate sector, rely on wholesale banks to act as lender-of-next-to-last-resort through prearranged lines of credit. Participants in the futures exchanges rely on wholesale banks for liquid funds to meet their margin requirements. Wholesale banks themselves rely on the interbank market to meet their end-of-day settlement obligations to the payments system. In addition, wholesale banks rely on liquid futures and money markets to lay off some of the risk of their OTC derivative book. Finally, the banking sector has come to rely on the central bank to keep the market for bank liabilities liquid by standing ready to act as lender-of-last-resort to the banking system.

In capital markets, trading strategies such as dynamic hedging rely on market liquidity for their success. For any one small player, the assumption of a liquid market with price continuity is probably reasonable. When all the selling strategies are triggered simultaneously, however, they have proved not to be feasible. The rest of the market participants may have no knowledge of the existence of such traders because their call orders lie buried in the future. They will come to the market only if triggered by the proper contingency. When the time comes for those massive sales to occur, the sellers may find no buyers prepared to take the other side of the market at the last reported price, and the price may suddenly collapse. A lack of liquidity in the market may cause a snowballing of sell orders. If the price falls dramatically below its fundamental value because of these liquidity problems, further sales may be triggered. Banks may make margin calls on their loans to security holders and dealers, and may cancel lines of credit. This may either bankrupt the holders and dealers or force a sale of their securities, further depressing prices.

The liquidity-related banking services supplied by central banks in liquidity-intensive financial systems typically include: (1) the fine-tuning or managing of liquidity in money markets through open market operations or through the provision of credit to the banking system on an ongoing basis; (2) various forms of support for the payments system, ranging from providing real time finality of gross payments to the provision of some form of credit facilities to solve temporary liquidity problems; and (3) lender-of-last-resort facilities, i.e., the supply of liquidity to the system during periods of extraordinary demand. Since the U.S. Federal Reserve provides intra-day payments finality, it is perhaps no accident that the U.S. dollar market has been most fertile for the development of derivatives. Similarly, by providing an unconditional liquidity (not solvency) guarantee for banks that are regarded as too large to fail, liquidity in derivative markets where banks are counterparties is assured.

In their basic operations, central banks have, therefore, long played two key roles—providing banking services and operating a monetary policy. The provision of banking services was chronologically first and remains operationally the more important of the two roles. This banking role had to be significantly strengthened in economies with liquidity-intensive financial markets and activities. The dynamic co-evolution of the financial industry and central bank financial liquidity-management policies precludes characterizing one or the other phenomenon as casual. If the central bank provides extensive liquidity services to the banking system, it creates a favorable environment for the development of a wider variety of liquidity-intensive activities in entities that are themselves short of liquidity. Alternatively, the development of such activities may force the central bank into giving the requisite liquidity support.

Degrees of Freedom in Monetary Policy

Liquid derivative markets allow participants to leverage their capital into large interest rate and currency positions very quickly. The size of leveraged positions tends to be very large compared with the resources at the disposal of a central bank seeking to defend a fixed exchange rate. Markets react quickly to signs of changing policy. For example, a new institutional player—the hedge fund—has an explicit objective of taking risk positions. Such privately held mutual investment vehicles alone are estimated to have capital of about 100 billion with leverage ranging anywhere from 10 to 50 percent.

The increasing institutionalization of equity and debt markets has added to this general phenomenon since institutions are more performance driven and transactions oriented and are more likely to use derivatives to establish positions. The room to maneuver for monetary and exchange rate policy has shrunk significantly. Noncredible policy will be put to severe tests.

In addition, derivative markets have made it possible to create synthetic deposits. Mutual funds can use derivatives, in particular put options, to ensure the capital value of all or a part of an investor’s portfolio. With its capital value insured, such a portfolio can then be used as a means of payment by the investor. Such synthetic bank liabilities have made it harder to interpret the behavior of monetary aggregates.

Conclusions

The growth of derivative finance has produced major gains in the efficiency with which risk is priced and savings are allocated. This development is irreversible. However, it is posing a major challenge to public policy. The supervisory and regulatory framework will need to be strengthened further to eliminate the risk of systemic disturbances emanating from this industry. In addition to increased capital requirements, increased disclosure, and improved accounting standards, it may also be necessary to consider changes in the structure of markets. An example would be to provide inducements—increased capital standards being one example—for off-balance-sheet over-the-counter business to be shifted into multilateral clearinghouses or even into organized exchanges. Risk management could then become more institutionalized. The historical fact that exponential growth in a particular banking activity has almost always led to problems adds some urgency to these reforms.

The growth of derivative finance has reduced the degrees of freedom for monetary and exchange rate policy. Market participants can establish large open positions with the leverage afforded by the use of derivatives. Thus the ability to defend an exchange rate against market pressure is much reduced. In addition, synthetic demand deposits created with the help of options have made monetary aggregates less reliable.

United States Board of Governors of the Federal Reserve System Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency“Derivative Product Activities of Commercial Banks: Joint Study Conducted in Response to Questions Posed by Senator Riegle on Derivative Products,”January 271993.

The author is grateful to Victor Ng for contributing valuable material on regulatory initiatives. The section on risks in derivative finance draws heavily on the Fund’s International Capital Markets: Developments and Prospects, Part II: “Systemic Issues in International Finance.”

For such contracts to be successful, certain conditions will have to be met. The most important of these is that the value of the underlying financial or real assets or index is well defined in all circumstances and beyond manipulation.

The theory of options pricing, as originally developed by Fischer Black and Myron Scholes, and used as a guide by market participants, analyzes the relationship between the market value of an option and the price of the underlying security—say, foreign exchange. As a currency’s value increases, so does the value of an option to buy that currency at a specified price—but not by a proportional amount, “Delta” is the change in the option’s value associated with a one-unit change in the currency’s value. Delta takes values between zero, for a deep out-of-the-money option that would never be exercised, and unity, for a deep in-the-money option that would always be exercised. Delta therefore provides a proxy for the probability that the option will be exercised, and therefore the proportion of the option’s face value that must be held at any time to hedge against possible exercise of the option. A “delta-weighted” hedge for a portfolio of currency options is constructed as follows. The bank calculates the delta for all of the contracts it has written and multiplies these by the face values of the contracts. These are added up for each currency to reach an estimate of the expected foreign currency requirement The hedge is then constructed using spot and forward positions in the underlying currencies.

As an example, suppose that the global position in the currency option book of a bank making a market In derivatives is short of one OTC option to deliver deutsche mark and to receive dollars (a put option). The delta-weighted hedge portfolio is constructed by finding the combination of a short position in deutsche mark loans and a long position in U.S. dollar loans, such that a portfolio with these positions and also short a put is riskless with respect to deutsche mark/U.S.dollar exchange rate movements. If the bank establishes these positions, it will have perfectly hedged its short put position.

According to a survey by the International Swaps and Derivatives Association (ISDA), 91 percent of swaps in the portfolios of its members were investment grade at end-December 1991. For end-users that do not have investment-grade credit ratings, the posting of collateral is one way to gain access to the OTC derivatives market. The ISDA is currently undertaking a project to standardize the documentation for collateralized swap contracts in an effort to improve the management of credit risk.

For example, in an interest rate swap if a bank agrees to deliver floating-rate interest payments and receive fixed-rate payments with a client, it may seek a balancing swap to deliver fixed-rate payments and receive floating-rate payments.

According to the 1992 ISDA default survey, U.K. local authorities were the source of almost 50 percent of the $358 million in cumulative losses incurred by dealers over the history of their involvement in swaps. The survey covered approximately 70 percent of swap dealers.

The report of the Bank for International Settlements (BIS) on netting schemes (the so-called Lamfalussy Report) endorses netting as a general risk reduction technique and suggests a speedy implementation of measures to ensure legal certainty

The potential for such problems was evident in the global stock market collapse of 1987, the bankruptcy of Drexel Burnham Lambert in 1990, and the recent European currency crisis. The market break in October 1987 was perhaps accelerated by trading in stock index futures, as prices in equity markets tended to lag behind those in the derivatives market owing in part to capacity constraints in the former. During the exchange rate mechanism (ERM) crisis in September 1992, the increased interest rate and exchange rate volatility led to strains in certain derivatives markets, such as OTC options, although the markets generally performed well at that time.

From “Challenges Posed by OTC Derivatives” (remarks of Susan M. Phillips, Member, Board of Governors of the Federal Reserve System, at the meeting of the National Futures and Options Society, New York, December 3, 1992).

Alternatively the models used to produce the theoretical hedge may be invalid. During the September 1992 ERM crisis, for example, interest rate volatility was far outside its normal range. Hedging models built on estimated volatility prescribed inappropriate mimicking portfolios to some currency and interest rate OTC options, thereby imposing serious losses on market-making banks.